Could you show with a suitable example involving real numbers how Risk-Reward or Profit-Loss ratios are calculated for a particular strategy. Let’s say we use simple moving average crossovers as a buying/selling strategy for this example. This would be of great help to a lot of us amateurs in risk management, and thus, to ensure our accounts don’t get wiped out.

One of the most interesting aspects of human nature is the reality that we humans take something simple and turn it into something complex. When we do this, we turn our ability to understand a thing upside down. For example, nutrition is a simple thing in general. The human body requires a certain amount of protein, carbohydrates, and fats to function efficiently. Granted, individual requirements vary to degrees, but, in general, the basic requirements are the same for all. Now, take the myriad conflicting nutritional studies over the years and it is clear that we have taken the simple and turned it into the complex. The result is people are so confounded that eating has turned into a job that requires specialized training.

Trading has fallen into the same trap. We need to always look at trading in the most fundamental and simple way. Basically, a trade consists of two parties negotiating to buy and sell a market. One asks for a price and the other bids a price. The two parties agree on a price or they don’t. Fundamentally, it is that simple.  

The same holds true for all aspects of trading, including defining profit/loss ratios – stick to the fundamentals. There is no complexity here. The calculation is simple. Take the total amount of trading capital you have ($1000), define a percentage of that capital designated for each trade (20% = $200), and then define a risk percentage for each trade (10% = $20) and a target profit for each trade (10% = $20). Yes, it is this simple. The actual numbers and ratios are particular to each person, but the fundamental principle remains – divide your trading capital into the maximum number of trades you can profitably make without losing all of your trading capital.

In the above hypothetical, one could make five trades at $200 per trade. If one follows the rules, one can lose no more than $20 per trade, or $100 in total for the five trades. This means one has to lose 50 trades with no wins to lose all of the trading capital.

Moving averages, or any other trading approach, have nothing to do with this basic calculation. So don’t confuse the issue. Define your total capital account and then define how much you can risk against how much you can make, making sure that you can make enough trades to make profit.

Trade in the day; invest in your life …

Trader Ed